Extraordinary Items, Earnings, Financial Statements

1. Explain the difference between horizontal and vertical analysis of the financial statements. Which method do you feel more comfortable with/understand better?

2. What are extraordinary items? Where are extraordinary items reported and why?

3. a. Identify and explain factors that affect quality of earnings.
b. Can you predict the stock price from analysis of the financial
statements?

Solution Preview

1. Vertical analysis is a method of comparing financial statements where all of the individual components are 'common sized' or written as a percentage of the total. In other words, if you were analyzing the balance sheet in this manner, and the total assets were $1,000,000 and cash was $50,000 you would record cash as 5% demonstrating the fact that 5% of all assets were held in cash. This process eliminates the differences caused by differing sizes of firms and helps to allow the user the ability to compare most firms in an industry to each other.

Horizontal analysis is another process of financial statement analysis where comparisons over time can be made. For example, suppose you have financial statements for XYZ corp. for 2006, 2007, and 2008. Using 2006 as the baseline, you would record the changes in each account made during the subsequent years. For example, if in 2006 the company reported sales of $1,000,000 and in 2007 they recorded sales of $1,100,000 you would report sales in 2007 under horizontal analysis of 110% or +10%. This helps the user to see exactly how an account changed without having to refer back to each year and makes the report easier to read and compare against different years.